Mortgage mayhem spreading! Markets plunging!

If you think yesterday’s 2.8% plunge in the Dow was severe, take a look at the shellacking of bank and brokerage stocks: Down 5%, 6%, even 7% across the board.

Why are things getting so hairy? Precisely because of the spreading mortgage market mayhem I’ve been warning about!

Virtually every day, another “tape bomb” — news of some unexpected loss in some part of the world — goes off.

Yesterday, it was France’s turn. BNP Paribas, the largest bank in that country, froze three funds that invest in asset-backed securities (ABS). Those are bundles of loans (credit cards, auto loans, etc.) that are packaged together into bonds and sold to investors who want to generate income.

BNP said it will not allow investors to deposit or withdraw money out of its three funds. In fact, it won’t even provide a value for the funds — Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia, which recently had combined assets of about $2.76 billion.

BNP’s reason for the freeze …

“The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating.”

In plain English, they’re saying that the subprime mortgage meltdown is causing pricing for all kinds of structured bonds to go haywire. Interestingly enough, BNP’s move caused problems of its own. Namely …

The European Money Markets Went Absolutely Haywire!

BNP Paribas was the latest bank to drop a subprime mortgage bomb on the markets.

The overnight London Interbank Offered Rate (LIBOR) soared to 5.86% from 5.35%, according to the British Bankers Association. That put it at the highest level since the start of 2001.

Let me explain why this is so significant …

The overnight LIBOR is what banks charge each other when they lend money back and forth for 24-hour periods. These extremely short-term loans are generally risk-free. I mean, what bank is going to get into so much trouble in 24 hours that it can’t pay you back?

Because of the low risk involved, LIBOR rates usually only move when central banks change their own rates. Since there were no major central bank changes made in the last day, the surge in LIBOR can only be tied to one thing: Abject fear of major bank losses!

This was so out of the ordinary, in fact, that the European Central Bank (ECB) responded by flooding the European money markets with a whopping $130 billion in instant liquidity. That was the single-biggest liquidity injection since the day after 9/11!

For months, we’ve had to listen to a bunch of government blather about how the housing and mortgage market problems are “well-contained.” We’ve been told not to worry … that it’ll all be over soon … or that the housing market “bottom” is in.

But if things are so contained, then why the heck are central bankers freaking out? Why are European policymakers throwing the most money at the markets since right after the biggest terrorist attack on U.S. soil in history?

It wasn’t just the ECB, either. The U.S. Federal Reserve followed up the ECB’s move by adding $24 billion in temporary money to our banking system. That was the most since April, according to Bloomberg. And the Bank of Canada felt it necessary to issue a statement saying that it will “provide liquidity” to “support the stability of the Canadian financial system and the continued functioning of financial markets.”

This Is a Stunning Reversal of Fortune in Just a Few Days

What makes this turn of events so amazing is that these emergency measures came just two days after the U.S. Fed met to talk policy.

What happened at that meeting? Well, in 1975, the New York Daily News ran a famous headline: “Ford to City: Drop Dead.” The paper was referring to Then-President Gerald Ford’s refusal to help the New York City government survive a financial crisis.

Ben Bernanke downplayed the risks of subprime mortgages just two days ago.

This week, Federal Reserve Board Chairman Ben Bernanke didn’t quite go that far. But he clearly stated that the Fed wasn’t going to come to the rescue of skittish hedge fund managers, private equity millionaires, and Wall Street head honchos.

Specifically, Bernanke kept interest rates unchanged on Tuesday. And while he acknowledged the credit problems in the market by saying,

“Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.”

… He also added language reiterating the Fed’s anti-inflation “bias,”

“Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

“Although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.”

In other words, there was no sign of panic … no hint that things were really coming unglued … and certainly no indication that within 48 hours, tens of billions of dollars of excess liquidity were going to be poured into the markets.

You know I’ve been chronicling the mortgage market’s struggles for several months. I’ve told you many a financial horror story. But if you can believe it, things are getting even worse. I’m literally seeing mortgage companies and mortgage stocks implode almost every day now …

HomeBanc Corp. (HMB), a lender with operations around the Southeast U.S., just announced it will stop originating mortgages. The company said it can’t borrow on its credit facilities and that it could no longer fund loans as of August 6.

Another lender, Aegis Mortgage out of Houston, suspended all of its mortgage originations as well. Said a company spokeswoman, “We’re going to have to suspend lending until we get this figured out.” Yikes!

Mortgage firm Delta Financial (DFC) tanked more than 40% on Wednesday. The company pushed back its scheduled earnings release, declining to say why or when it would release an update.

Mortgage REIT Luminent Mortgage Capital (LUM) just said it would suspend its dividend payments and push back an earnings conference call it had previously scheduled. Lenders are increasing margin calls and pulling back on funding for the company’s operations. The stock plunged 30.8% on Monday alone, then kept on falling. It’s now down a whopping 92% in 2007.

You know what Luminent’s CEO recently said? “In my almost 30 years in the U.S. mortgage-backed securities market, I have never before seen the intensity of confusion, uncertainty and outright fear as right now.”

In other words, things are ugly with a capital “U!”

Here’s My Message to You …

These developments have been coming at traders fast and furious. That’s why you’re seeing such violent swings in the market, with the Dow down almost 300 points one day, then up 300 points the next.

My suggestion: Don’t focus on the day-to-day swings. Focus on the big picture. And that big picture can be best described as follows:

1. The credit markets are in disarray …

2. The fundamentals in the housing and mortgage markets remain dismal …

Money and Markets(MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Adam Shafer, Andrea Baumwald, Kristen Adams, Maryellen Murphy, Red Morgan, Jennifer Newman-Amos, and Julie Trudeau.

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